Wall Street crisis deepens and Banks rush to do deals

NEW YORK (Reuters) – Manic and increasingly desperate dealmaking gripped Wall Street on Wednesday as U.S. stocks plummeted to three-year lows amid new signs of distress in the global financial industry.

Morgan Stanley was discussing a merger with regional banking powerhouse Wachovia, the New York Times reported. CEO John Mack got a phone call from Wachovia on Wednesday but is also pursuing other options, the paper said.

“In this market, anything’s possible. It seems like the market wants the investment banking model to disappear,” said Danielle Schembri, bond analyst covering brokers at BNP Paribas in New York.

Washington Mutual , the country’s largest savings bank, put itself up for sale, sources said, confirming a New York Times report. Potential suitors include Citigroup, JPMorgan, Wells Fargo and HSBC, they added.

The flurry of potential deals followed the surprise $85 billion rescue of insurer American International Group by the U.S. Federal Reserve on Tuesday that did little to calm investors’ nerves.

“Stop The Insanity,” pleaded a research note from Swiss bank UBS as U.S. financial shares appeared to be in free-fall. The U.S. stock market plunged 4.7 percent to a three-year low, the dollar slumped and safe-haven U.S. Treasury bonds soared.

The AIG rescue capped a week of bailouts, a bankruptcy on Wall Street and moves by central banks around the world to flood the financial system with funds to prevent it from seizing up.

The result: a seismic shift in the financial industry, with some of Wall Street’s biggest names disappearing.

“The fear is who is next,” said John O’Brien, senior vice president at MKM Partners in Cleveland. “It almost feels like people scour the books and say who is the next likely target that we can put a short on. And that spreads continuous fear.”

Shares of Morgan Stanley and larger rival Goldman fell as much as 43 percent and 27 percent respectively, even after both reported better-than-expected quarterly earnings on Tuesday.

That stoked talk Wall Street’s two surviving investment banks may have to join up with a commercial bank to survive.

“I’m assuming that Goldman Sachs and Morgan Stanley are lining up dancing partners. They don’t want to be … this week’s victim,” said William Larkin, fixed income manager at Cabot Money Management in Salem, Massachusetts.

EMPTY SEATS

The White House said it was “concerned about other companies” while the U.S. presidential candidates struck populist tones, with John McCain blasting Wall Street’s “casino culture” and Barack Obama stressing protection for mom-and-pop investors.

The objects of their ire were glued to their trading screens. In the capital of the hedge fund industry, Greenwich, Connecticut, an industry conference for 500 people had 200 empty seats.

“A lot of people who are seeing massive red ink and are suffering the most are not here,” said Jean de Bolle, the chief investment officer at Byron Advisors.

The cost of protecting Morgan Stanley’s and Goldman’s debt spiked, reflecting investor fears their debt issues are no safer than junk bonds.

“The credit crunch and credit contraction is intensifying,” said Peter Boockvar, equity strategist at Miller Tabak & Co in New York. “The action in Morgan Stanley in light of what was better-than-expected numbers last night is disconcerting.”

Goldman spokesman Lucas van Praag said the drop in his company’s share price was “the result of completely irrational fear and is not based on any fundamentals.”

Morgan Stanley’s Mack blamed short sellers, or investors who bet on falling stock prices, saying in an internal memo: “We’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down.”

PROPPING UP THE SYSTEM

In the latest example of regulatory action with little apparent effect, the U.S. Securities and Exchange Commission curbed short-selling.

“Seems like the SEC is a day late on the rule … Morgan Stanley is clearly in the short-sellers’ sights,” said Andrew Brenner, senior vice president at MF Global in New York.

New distress signals had popped up earlier. The cost of borrowing overnight dollars spiked above 10 percent, indicating a deep lack of trust in the interbank lending market.

The HBOS merger talks underscored how quickly authorities around the world are ditching long-held beliefs about free markets as they struggle to counter the credit crunch.

Lloyds was previously blocked from buying a smaller mortgage bank, and the British government shocked investors by taking over troubled bank Northern Rock in February — the country’s first major nationalization since the 1970s.

U.S. authorities already have spent $900 billion to prop up the financial system and housing market. Authorities may get much of that money back — if asset prices do not slide further.

The AIG rescue came just over a week after the bailout of mortgage finance companies Fannie Mae and Freddie Mac, and six months after the Fed brokered the sale of failed investment bank Bear Stearns to JPMorgan Chase .

Two legendary firms bit the dust over the weekend. Lehman Brothers Holdings Inc filed for bankruptcy and Merrill Lynch & Co CEO John Thain struck a deal to sell the firm to Bank of America Corp.

“Thain at Merrill Lynch did a very smart thing … in keeping shareholders from being swallowed up by this vortex,” said Jeff Gundlach, CEO at bond manager Trust Company of the West in Los Angeles.